Price Action Analysis in Trading

In this article, we will delve into the concept of Price Action Analysis in Trading. This analysis method focuses on understanding the movement of prices in a chart, specifically through the use of candlestick patterns. By comprehending the basic and advanced features of candlesticks, traders can gain insights into the actions of buyers and sellers during specific time periods.

Exploring the Advanced Features of Candlesticks

Before we proceed, let's take a moment to revisit our previous article, which covered Candlestick Analysis in Trading. Familiarity with candlestick patterns is essential for comprehending price action analysis. Once you grasp the content of this article, you will no longer need to rely solely on recognizing candlestick patterns.

What is Price Action Analysis?

Price Action Analysis revolves around studying the price movement displayed in a chart. Candlestick patterns offer a clear representation of price action, illustrating the activities of buyers and sellers within a given timeframe. Therefore, to understand price action, it is crucial to become well-versed in the fundamental and advanced aspects of candlestick analysis.

Five Steps to Candlestick Analysis

Step 1: Evaluating the Size of the Candlestick Body (High to Low)

The body of a candlestick contains a wealth of information:

- A long body indicates strength.

- A narrow body signifies weakness.

- Consecutive bodies that increase in size suggest growing momentum.

- Consecutive bodies that decrease in size indicate a slowdown in momentum.

- When an up or down move is accompanied by a larger-than-average body, it signifies high volatility.

To make effective comparisons, consider the current candlestick in relation to the previous candlestick, the same swing, or the previous swing.

Step 2: Assessing the Length of the Candlestick's Wick

The length of a candlestick's wick provides valuable insights:

- Longer wicks indicate significant price movement during the candle's duration, which experienced rejection, highlighting the presence of supply or demand.

- At major support and resistance levels, candle wicks tend to be larger, signifying increased volatility. This typically occurs after extended trending phases, preceding a reversal from the support or resistance level.

- It's important to note that the longer the shadow, the more likely prices will move in the opposite direction of the shadow.

- Long-wick candles don't always indicate a reversal. If subsequent price action engulfs the wick of a rejection candle, it is considered a failed reversal, known as a reverse rejection.

- If long wicks appear within a trend, it suggests a temporary pullback in a smaller timeframe, indicating continuity in the overall trend if the body closes in the direction of the trend.

Step 3: Analyzing the Ratio between Wicks and Bodies

Understanding the relationship between the open and close prices concerning the high and low of the current candlestick is crucial:

- The open price reveals the balance between buyers and sellers at the beginning of the period.

- The close price indicates the balance point at the period's end.

Step 4: Factoring in Volume

WYCKOFF BASIC LAW

To comprehend price action accurately, it is vital to consider the interplay between supply and demand:

- The Law of Supply and Demand states that when demand surpasses supply, prices will rise accordingly, and vice versa.

- The Law of Cause and Effect establishes a proportional relationship between the cause (volume action) and the effect (price action). A large cause results in a substantial effect, whereas a small cause produces a minor effect.

- The Law of Effort vs. Result asserts that the price action on the chart must reflect the volume action beneath. The relationship between effort (volume) and result (price) should be validated and any anomalies should be considered.

Wide Spread Candle

Price Action:

- A strong bullish market sentiment is indicated by a sharp upward price action, closing near the high of an upward candle.

Volume Action:

- Correspondingly, the associated volume should exhibit strength, validating the prevailing sentiment. For example, if the volume is above average, it aligns with expectations and confirms the price movement. It indicates that knowledgeable investors are participating in the upward trend, suggesting a healthy market.

- Conversely, if the volume is below average or low, it serves as a warning signal. Despite the price rising, there is minimal effort behind it. The upward movement lacks genuine support. In such cases, traders holding positions should consider exiting, while those without positions should exercise caution and await signals indicating where the smart money is currently moving.

Narrow Spread Candles

Price Action:

- A narrow spread candle suggests weak market sentiment.

Volume Action:

- A narrow spread candle should ideally be accompanied by low volume, maintaining the effort vs. result relationship.

- However, if a narrow spread candle occurs with high volume, two possibilities arise:

   1. The smart investors are selling into buying, possibly signaling the end of a rising market.

   2. There is a trading range to the left, and the smart investors are absorbing selling from traders locked into that range.

Step 5: Relative or Two-Candle Price Action

Direction of Candle:

- The relationship between each bar's high/low compared to the previous bar is crucial in determining price direction.

- An upward bar commences an upswing and confirms the end of a downswing.

- A downward bar initiates a downswing and confirms the end of an upswing.

- Inside bars, which do not break the previous high or low, do not influence the direction of the current swing.

- An outside bar breaks both the previous high and low, introducing uncertainty into the market structure. An outside bar within an upswing continues the upswing, while an outside bar within a downswing continues the downswing. Typically, an outside bar does not signal the end or start of a price swing unless a subsequent down bar occurs or the swing low is breached in the case of an upswing.

Direction of Trend with Respect to Candle Position

Context or Background:

- It is crucial to analyze candlesticks in the context of past events.

- Consider whether the current candlestick is larger or smaller than previous ones, indicating increasing or decreasing momentum.

- Observe whether the changes in size hold significance, indicating buying or selling pressure.

- Note any shifts in volatility.

- Consider whether these changes occur during an active trading period. Candlesticks formed in the middle of a trading period tend to be less active.

Testing Price Levels

Testing refers to the market moving towards a price level to gauge whether it will accept or reject the market's advances. The high and low of each price bar serve as natural support and resistance levels, while the wick typically represents a supply and demand zone. Testing these levels or zones provides insights into the market's underlying dynamics and is crucial for interpreting price action.

Three Price Bars/Expectation

By accurately interpreting two-bar price action (direction, context, and testing), traders can form expectations for the market's behavior in the third candle. Expectations are based on the assumption that market behavior should generally align with its momentum and inertia. Bearishness should follow bearishness, and bullishness should follow bullishness. Any deviation from this assumption warrants caution and may signal a potential change in market direction.

Some more examples

In the next article, we will continue our discussion on Price Action Analysis. This installment will focus on the step-by-step process of studying candlesticks, identifying swing highs and swing lows, and recognizing their characteristics. We hope you find this Price Action Analysis in Trading article informative and enjoyable.

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